ch 12+13 production and costs -...
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CH 12+13Production and Costs
ECONOMIC PROFIT VERSUS
ACCOUNTING PROFIT
Explicit Costs versus Implicit Costs
• Explicit cost =money paid out (rent, wages, etc.)
• Implicit cost=opportunity cost of the factors of production used by the firm
Economic Profit versus Accounting Profit
• Economists and accountants measure profit differently
• Unlike accountants, economists also consider implicit costs (the opportunity cost of what they could have done instead)
Economic Profit versus Accounting Profit
• Economists focus on both explicit and implicit costs and revenue• Economic profit = (explicit + implicit revenue) –
(explicit + implicit cost)
• Accountants focus on explicit costs and revenues• Accounting profit = explicit revenue – explicit cost
Economic Profit versus Accounting Profit
•When discussing costs, if a firm is making zero economic profit they are always making a positive accounting profit•This is because accounting profit does not take into consideration the opportunity cost of what they could have done instead
COSTS OF PRODUCTION
Short run versus Long run
• The short run is the period in which at least one input (resource) is fixed• Plant size cannot be changed
• In the long run all inputs (resources) are variable• There are no fixed resources• Plant size can be changed
Costs of Production• Fixed costs (FC) are those that cannot be changed in the
period of time under consideration
• In the short run, a number of inputs and their costs will be fixed
• In the long run, there are NO fixed costs since all inputs are variable
• Examples: Rent, insurance, salaries of managers
Costs of Production
•Variable costs (VC): costs for variable resources that change as output changes•Examples: Raw materials, labor, utilities
Costs of Production
•Total cost (TC) is the sum of the variable and fixed costs•TC = FC + VC
Costs of Production
• Average fixed costs (AFC) equals fixed cost divided by quantity produced• AFC = FC/Q
• Average variable costs (AVC) equals variable cost divided by quantity produced• AVC = VC/Q
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The Costs of Production • Average total cost (ATC) equals total cost divided by
quantity produced• ATC = TC/Q or ATC = AFC + AVC
• Marginal cost (MC) is the additional cost when output increases by one unit• MC = ΔTC/ΔQ
Costs of Production Table
Output FC ($) VC ($) TC ($) MC ($) AFC ($) AVC ($) ATC ($)
3 50 38 8812
16.67 12.66 29.33
4 50 50 100 12.50 12.50 25.00
9 50 100 1508
5.56 11.11 16.67
10 50 108 158 5.00 10.80 15.80
16 50 150 2007
3.13 9.38 12.51
17 50 157 207 2.94 9.24 12.18
22 50 200 25010
2.27 9.09 11.36
23 50 210 260 2.17 9.13 11.30
27 50 255 30515
1.85 9.44 11.29
28 50 270 320 1.79 9.64 11.43
32 50 400 450 1.56 12.50 14.06
Example: Calculating Costs
Output VC FC TC MC AVC AFC ATC
0 $0 $10 $10 -- -- -- --
1 $10 $10
2 $17 $27
3 $25 $10
4 $40
5 $60 $10 $70
Fill in the chart below
Example: Calculating Costs
Output VC FC TC MC AVC AFC ATC
0 $0 $10 $10 -- -- -- --
1 $10 $10 $20 $10 $10 $10 $20
2 $17 $10 $27 $7 $8.50 $5 $13.50
3 $25 $10 $35 $8 $8.33 $3.33 $11.66
4 $40 $10 $50 $15 $10 $2.50 $12.50
5 $60 $10 $70 $20 $12 $2.00 $14
Fill in the chart below
The Shapes of Cost Curves • The average fixed cost (AFC) curve is downward sloping
• Increasing output decreases AFC
• The marginal cost (MC), average variable cost (AVC), and average total cost curves (ATC) are U-shaped
• Increasing output initially leads to a decrease in MC, AVC, and ATC but, eventually they increase
MC, ATC, AVC, and AFC
AVC
MC
ATC
AFCQ
Cost
AFC curve decreases
MC, ATC, and AVC curves
are U-shaped
35
30
25
20
15
10
5
04 8 12 16 20 24 28 32
The Shapes of Cost Curves
• The marginal cost curve goes through the minimum points of the ATC and AVC curves (remember this)
• When the marginal cost is below the average, it pulls the average down
• When the marginal cost is above the average, it pulls the average up
Draw the Graph: Marginal Cost, AVC, and ATC
AVC
MC
Q
Costs per unit
ATC The marginal cost curve goes through the minimum point of both the ATC and AVC curves
•If MC > ATC, then ATC is rising
•If MC > AVC, then AVC is rising
•If MC < ATC, then ATC is falling
•If MC < AVC, then AVC is falling
•If MC = AVC and MC = ATC, then AVC and ATC are at their minimum points
The Relationship Between Marginal Cost and Average Cost
The Shapes of Cost Curves • The variable and total cost curves have the same shape
• Increasing output increases VC and TC
• The fixed cost curve is always constant• Increasing output doesn’t change FC
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Graphing Total Cost Curves
FC
Total Cost
FC curve is constant
TC and VC curves increase as Q increases
Q
500
400
300
200
100
04 8 12 16 20 24 28 32
VC
TC
DIMINISHING MARGINAL RETURNS
Law of Diminishing Marginal Returns
•Law of diminishing marginal returns (productivity): as more of a variable input is added to an existing fixed input, after some point the additional output from the additional input will fall
Law of Diminishing Marginal Returns
# of workers
Total Output
MarginalProduct
Average Product
0 04
6
7
6
5
3
1
0
-2
-5
---
1 4 4
2 10 5
3 17 5.7
4 23 5.8
5 28 5.6
6 31 5.2
7 32 4.6
8 32 4.0
9 30 3.3
10 25 2.5
Increasing marginal returns
Diminishingmarginal returns
NegativeMarginal returns
The Three Stages of Returns (Production Function)
• The production function tells the maximum amount of output that can be derived from a given number of inputs• Note it has three stages
Graphing the Three Stages of Returns (Production Function)Q
Increasing marginal returns
Diminishingmarginal returns
Negative marginalreturns
Number of workers
TPA production
function is the relationship
between inputs and outputs
32
26
20
14
8
2
1 2 3 4 5 6 7 8 9 10
Three Stages of ReturnsStage I: Increasing Marginal Returns
MP is rising. TP is increasing at an increasing rate. This is due to specialization.
Total Product
Quantity of Labor
Marginal and
Average Product
Quantity of Labor
Total Product
Average Product
Marginal Product
Three Stages of ReturnsStage II: Decreasing Marginal Returns
MP is falling. TP is increasing at a decreasing rate. This is due to fixed resources. Each worker adds less and less product.
Total Product
Quantity of Labor
Marginal and
Average Product
Quantity of Labor
Total Product
Average Product
Marginal Product
Stage III: Negative Marginal ReturnsMP is negative. TP is decreasing.
Workers are now getting in each other's way, resulting in less productivity.
Three Stages of Returns
Total Product
Quantity of Labor
Marginal and
Average Product
Quantity of Labor
Total Product
Marginal Product
Average Product
Relationship between Production and Cost
MP
MC
As more workers are hired, their marginal product increases and then eventually decreases because of the law of diminishing marginal returns
The additional costs (MC) of the units they produce falls when MP goes up, but eventually increases as additional workers produce less and less output
Quantity of output
Quantity of labor
Output
Costs
MP and MC are mirror images of each other
TOTAL REVENUE AND
TOTAL COSTS
Total Revenue and Total Cost
•Total Revenue= Price x Quantity
•Total revenue and total cost curves can be used to determine the profit-maximizing level of output •Total cost is the cumulative sum of the marginal costs, plus the fixed costs
•Total profit is the difference between total revenue and total cost curves
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Total Revenue and Total Cost Table
Q Total Revenue ($) Total Cost ($) Total Profit ($)
0 0 40 -40
1 35 68 -33
2 70 88 -18
3 105 104 1
4 140 118 22
5 175 130 45
6 210 147 63
7 245 169 76
8 280 199 81
9 315 239 76
10 350 293 57
Total profit is maximized at 8 units
of output
Total Revenue and Total Cost Table
TC
$175
Q
$130
$280
85
TRThe total revenue curve is a
straight line
The total cost curve is bowed upward at most
quantities reflecting increasing marginal cost
Could see this graph in the multiple choice
3
Losses LossesProfits
Profits are maximized when the vertical distance
between TR and TC is greatest
11
Chapter Summary • Accounting profit is explicit revenue less explicit cost
• Economists include implicit revenue and cost in determining economic profit
• Implicit revenue includes the increases in the value of assets owned by the
firm
• Implicit costs include opportunity cost of time and capital provided by owners
of the firm
• In the long run a firm can choose among all possible production techniques; in
the short run it is constrained in its choices because at least one input is fixed
Chapter Summary • The law of diminishing marginal productivity states that as more of a variable
input is added to a fixed input, the additional output will eventually be
decreasing
• Costs are generally divided into fixed costs, variable costs, and marginal costs
• TC = FC + VC
• MC = ΔTC/ΔQ
• AFC = FC/Q
• AVC = VC/Q
• ATC = AFC + AVC
Chapter Summary • The law of diminishing marginal productivity causes marginal and average costs
to rise
• MC goes through the minimum points of the AVC and ATC
• If MC > ATC, then ATC is rising
• If MC = ATC, then ATC is constant
• If MC < ATC, then ATC is falling
LONG RUN COSTSAND
ECONOMIES OF SCALE
Returns to Scale
•Returns to scale indicates what happens to productionin the long run• If output more than doubles, increasing returns to scale
occurs
• If output doubles, constant returns to scale occurs
• If output less than doubles, decreasing returns to scale occurs
•Note: Returns to scale is only looking at production, not costs
Long run ATC (LRATC)
• The law of diminishing marginal returns does not apply in the long run since all inputs are variable
• The shape of the long-run cost curve is due to the existence of economies and diseconomies of scale • Here, we are looking only at costs of production
Long run ATC (LRATC) and Economies of Scale
•Economies of scale exist when long-run average total costs decrease as output increases•These are shown by the downward sloping portion of the long-run ATC
• Why does economies of scale occur?• Firms are able to use mass production techniques and
specialization to produce more• Think of the car industry
Long run ATC (LRATC) and Economies of Scale
• Constant returns to scale exist when average total costs do not change as output increases
• This is shown by the flat portion of the long-run average total cost curve
• Constant returns to scale occur when production techniques can be replicated again and again to increase output
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Long run ATC (LRATC) and Economies of Scale
•Diseconomies of scale exist when long-run average total costs increase as output increases
•These are shown by the upward sloping portion of the long-run average total cost curve
A Typical LRATC
Q
Costs per unit
11
$50
$55
17
$60
14 20
(LRATC)
Economies of scale Constant returns to scale
Diseconomies of scale
Minimum efficient level
of production
LRATC Table
QTC of Labor
($)TC of Machines ($) TC ($) ATC ($)
11 381 254 635 58
12 390 260 650 54
13 402 268 670 52
14 420 280 700 50
15 450 300 750 50
16 480 320 800 50
17 510 340 850 50
18 549 366 915 51
19 600 400 1000 53
20 666 444 1110 56
ATC falls because of economies of
scale
ATC is constant because of
constant returns to scale
ATC rises because of
diseconomies of scale
Chapter Summary • An economically efficient production process must be technically
efficient, but a technically efficient process may not be economically efficient
• The long-run average total cost curve is U-shaped because economies of scale cause average total cost to decrease; diseconomies of scale eventually cause average total cost to increase
• Marginal cost and short-run average cost curves slope upward because of diminishing marginal productivity
• The long-run average cost curve slopes upward because of diseconomies of scale
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